Sunday, May 22, 2022

Earnings Management vs. Accounting Fraud

People often ask me what's the difference between earnings management and accounting fraud well they both involve manipulation of the financial statements but accounting fraud goes so far as to break the law investors are being deceived about what the company's sales are or its expenses .

Whereas earnings management is just changing the timing of transactions to be able to hit an earnings goal let me give you an example let's say that a company is expected to have a hundred million dollars in profit this quarter on a pre-tax basis but the current profit is expected to be 98 million .

So they're expected to hit 100 million but they actually think they're going to hit 98 million so they're going to be 2 million short of what the target is so let's say a company says hey we want to hit 100 million we want to make our target but we're going to be short so let's do .

Something about it well let's say that the company had an available for sale debt investment that had an unrealized gain of 3 million now in the united states at the time i'm making this video if you were to sell an available for sale debt investment .

You would realize a gain that would affect the company's net income okay so it's going to affect the net income in unrealized gain on an available for sale debt investment on the other hand has no effect on the company's net income it goes through another account called .

Other comprehensive income so they had this unrealized gain of three million that affected other comprehensive income but not an income and they say okay well if we sell this available for sale debt investment the gain goes from being unrealized and affecting other comprehensive income to being realized and affecting net .

Income so simply by saying we're going to sell this available for sell debt investment they generate three million dollars of pre-tax income so now it's so they were on pace to have 98 million dollars of profit but if you add in that 3 million now they're at 101 .

And they were the what analysts or whoever was expecting them to hit was 100 million they now hit 101 so they have achieved their profit target there was nothing happened that here that was illegal they simply they had an investment and due to accounting rules it wasn't booked until net income until .

They sold the investment so they decided let's sell the investment so we can book that three million dollars as profit and take us from 98 million pre-tax to 101 million pre-tax that's an example of earnings management no laws were broken here but they did change the timing of a .

Transaction in order to hit a profit target situation number two let's say the company so let's let's disregard this here now let's forget about the available for sale debt and let's say that they're on pace to have 98 million dollars of profit pre-tax and they're wanting to hit .

A hundred million at least okay so they instead in situation two they say you know what we're gonna create a bogus sale we're gonna even though we have not made a sale to a customer we're gonna record as if we had made a five million dollar sale to a customer so we're gonna recognize five million dollars of sales .

Revenue and let's say we got two million dollars of cost of goods sold right because if we're making a fake sale we also got to recognize that cost of goods sold even though it's a fake sale right so you got to pretend like it's an actual sale so 5 million .

Minus two million so that's a three million dollar increase on a pre-tax basis in the company's profit okay so now by recording that fake sale we again went so from 98 million was what we're on track let's say it was the last day of the quarter and we're like oh we're 98 million we need to get to 100. and .

Now we add in that extra 3 million we're at 101 now we have exceeded the target okay now this could be the analysts were expecting that level of profit or it could be that the management is going to get a bonus right so maybe to get a bonus management needed to hit .

100 million and so they were at 98 and they were like no i really want that bonus i already told my family i'm gonna get a pool so they said okay well we need to do something to get up or over 100 million now you can see that this is fraud right you have deceived investors this .

Is a i'm talking about a fictitious sale here you didn't sell anything to anybody you just made it up you made up a fail a fake sales invoice you you made up some fake shipping documents you made it look like you had a sale when you actually did not so this situation is fraud whereas the first situation .

Was earnings management

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